HFT: The latest on rebates, taxes and 'speed bumps'

Not surprisingly, there are all sorts of proposals flying around on what to do—if anything—about high-frequency trading.

Here's my prediction: there will be hearings by both the Congress and the Securities and Exchange Commission, but it's very unlikely anyone is going to do anything radical anytime soon.

I believe there is great concern about the Law of Unintended Consequences. The SEC spent years debating what would happen if regulators enacted Reg NMS, which codified rules for dark pools, allowed stock exchanges to pay rebates, and generally, vastly encouraged the markets to "speed up."

Seven years later, they are still sorting out the consequences, one of which is high-frequency trading.

Today, I was on the air with former Sen. Ted Kaufman, who called for eliminating rebates to exchanges, and, by extension, the ability of discount brokers to receive payment from other brokerage firms for sending their order flow to them.

Why do companies pay for order flow? The rationale—from the point of view of the discount brokers—was why should we pay for maintaining increasingly expensive, massive trading systems? Why not outsource that part of the business? Our customers want low payments for commissions. That's what matters most.

So, a business model developed along those lines. A more thoughtful, systematic approach is needed, because there are other issues as well.

One issue worth examining is a so-called "speed bump" that would slow traffic down by a few milliseconds.

Here's the core of the problem: because there are 13 different exchanges and some 40 dark pools, market makers, high-frequency traders—really, anyone who wants provide bids and offers in the marketplace—have to post their bids and offers on all the exchanges. This leads to a big problem: if someone posts an offer to sell, say, 100 shares of Pfizer and that offer is taken, the trader posting the offer then has to cancel all the other offers on all the other exchanges.

You can see the frustration this causes: constantly cancelling bids and offers on the exchanges means there is a huge amount of "phantom" liquidity in the market.

That's one issue. Here is another problem: high-frequency traders, because they pay for faster lines, can get to the "slower" exchanges faster than others, cancel those offers that are no longer relevant ... and then make a new offer a penny higher!

This is the source of all the complaints that high-frequency traders are "front running" other traders. This is legal, so it is not technically front running, but it does raise fairness issues.

It has also led to complaints that high-frequency traders are displacing the real market makers who are willing to take risk.

What to do?

There has been a lot of talk of a "fee" or "tax" on excess message traffic. That would certainly reduce a lot of the traffic, but there is a lot of resistance to the idea of any kind of tax.

A more interesting idea is the "speed bump," which would require a delay between the time an order arrives and the time it is allowed to execute. The problem, as I have written many times, is that if there is simply a delay of, say, one second, then the minute you end that one second, the faster machines still have the advantage. You've just reset the clock a second later.

One proposal to change this is that each order be held for some random time period, say 10 to 200 milliseconds. By randomizing the time the order is held, no one would know how much the order is slowed. The number could be generated randomly by a computer. The end customer, the argument goes, would not care about a fifth of a second delay. However, the high frequency trader very much would.

The bottom line: this is not an easy issue. Before we throw everything out and completely crash the system, let's look at it in a "holistic" way. Let the SEC come out with hearings and a definitive timetable to come up with a statement on what is right with trading (and there is plenty) and what is wrong with it.